Information provision in financial markets

Abstract

We set up a rational expectations model in which investors trade a risky asset based on a private signal they receive about the quality of the asset, and a public signal that represents a noisy aggregation of the private signals of all investors. Our model allows us to examine what happens to market performance (market depth, price efficiency, volume of trade, and expected welfare) when regulators can induce improved information provision in one of two ways. Regulations can be designed that either provide investors with more accurate information by improving the quality of prior information, or that enhance the transparency of the market by improving the quality of the public signal. In our rational expectations equilibrium, improving the quality of the public signal can be interpreted as a way of providing information about the anticipations and trading motives of all market participants. We find that both alternatives improve market depth. However, in the limit, we show that improving the precision of prior information is a more efficient way to do so. More accurate prior information decreases asymmetric information problems and consequently reduces the informativeness of prices, while a more accurate public signal increases price informativeness. The volume of trade is independent of the quality of prior information and is increasing in the quality of the public signal. Finally, expected welfare can sometimes fall as prior information or the public signal become more precise.